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Spinning the wheel in retirement

A common perception in finance is that the risk in growth assets, like equities, declines over a longer investment horizon. Recent research by consulting economists, Drew, Walk & Co into the equity risk premium (ERP) shows that even over the long run, equity investing is like a chocolate wheel: there are plenty of winners, but also losers. Retirees should not assume that the volatility of equity returns will be smoothed out over time, not even over 20 years. Retirees need to factor this into their goals for retirement income.

What is the ERP?

The ERP is the additional return that investors require, on average, for taking the extra risk of investing in equities, over and above any risk-free return (the government bond return). If investors do not expect to receive this additional return, they won’t invest in the risky asset.

The ERP has been labelled the most important variable in finance and is used in a number of applications. Just about every decision in finance has a link to the ERP.

Unlike a long-term bond, where an investor can hold to maturity and receive a known term premium, the equity premium is unknown in advance and is far from certain. The challenge for investors and superannuation fund members is the range of actual equity return outcomes, compared to the originally expected ERP.

The (un)predictable equity risk premium

In their paper, Drew, Walk & Co explore whether investing in equities in previous 20-year periods was adequately rewarded for the risk taken. They calculated the historical equity return (out)performance over various periods in a range of jurisdictions. The report concludes, among other things, that the equity return (out)performance:

  • is uncertain, and its timing and magnitude are unpredictable
  • has shrunk in recent history to below its long term average in Australia
  • was only 1% per annum for the last 20 years.

The flaw of averages

Traditionally, the ERP is calculated by averaging the entire period of available historical data, and this average is then used to make an assessment of future returns. In using such an average, people miss the fact that an Australian retiree household is planning for roughly 30 years, which is obviously well short of the 115 years since 1900.

Long-run historical average returns can be flawed because:

  • They are not an indicator of future outcomes.
  • There are potential survivorship biases, where losses incurred in failed companies are not properly included.
  • The early history reflects the benefit of Australia emerging as a financial economy. Since WWII, Australian equities have actually performed lower than prior decades and in line with other major global markets.
  • Most people do not get the average outcome. Around 50% will do better and a similar proportion will do worse.

In addition, retirement is different, because most retirees:

  • Need to spend their capital and so are impacted by sequencing risk.
  • Segment their retirement capital over a range of time horizons within their retirement timeframe, to meet their investing and spending goals.
  • Won’t have an unbroken exposure to equities for decades.

Time doesn’t diversify equity risk

Most people assume that 20 years is long enough to get the ‘long-run average’, however the research indicates that there are a wide range of potential outcomes, even when they can stay invested for 20 years.

Only with hindsight, at the end of the 20 years, will a retiree find out their premium (if any) for taking equity risk over that period.

Figure 1 shows the frequency of the 20-year historical equity return (out)performance. The graph shows that Australia performed better in the first half of the 20th century, when it would still have been an emerging economy rather than the fully developed market economy it is today. There have been 14 periods of 20 years in Australia where the equity return outperformance exceeded 10% per annum, but they were mostly before WWII (shown in light green).

Figure 1: Distribution of 20-year Australian outperformance

The typical retiree needs some equity exposure

Even though equity investing is volatile over the long range, most retirees typically have the time horizon and risk tolerance to invest in at least some equities and they are likely to benefit from the premium. This is why the great majority of account-based pensions already have a generous exposure to equities.

A retirement risk management strategy

But what do retirees do about the equity risk? What happens when something goes wrong? Instead of adopting a conventional ‘set and forget’ approach, well-advised retirees work with a risk management strategy for their equity exposure in retirement. The idea of having a safety strategy is common in everyday life, and when it comes to investing in risky assets, retirees should be no different.

Using a long-term bucket for equities in retirement is one strategy that is sometimes used. However, as equity outperformance is uncertain over 20 years, a retiree will not have certainty about how much will be in the bucket after even as long as 20 years.

Portfolio allocation in retirement

Starting with Chhabra (one of the early papers that advocated goals-based investing rather than efficient frontier targeting), there has been a distinctly different approach for making asset allocation decisions in retirement. This approach is to consider the full range of the retiree’s objectives and goals. Instead of trying to meet all targets with one investment decision, a goals-based approach will segment the main objectives. The approach is similar to the asset-liability matching practised by many insurance companies and defined benefit funds around the world.

Matching objectives enables a retiree (or their adviser) to consider the risk/reward trade-off that is represented by the ERP and select a suitable allocation of risk for each objective. For example:

  • Generating income for life to meet essential spending needs will generally have a limited exposure to risky assets, as the objective is to maintain a minimum standard of living for life.
  • Investing for spending on holidays and luxuries later in retirement can have a higher allocation to growth assets.

Under this approach, retirees with differing objectives, but the same wealth, age and risk tolerance will actually have different asset allocations.

Spinning the chocolate wheel in retirement

Retirees should think about investing as being like spinning the chocolate wheel shown. This has been assembled using the global historical numbers, the average of which roughly matches the forward projections for the ERP made by Drew, Walk & Co. in their paper.

Figure 2: Chocolate wheel of global historical average annual equity return outperformance over-20 year periods

This ‘chocolate wheel’ reminds retirees that the average annual outperformance that might be expected over a 20-year investment period is not certain. It will not be a guaranteed rate. Most outcomes are attractive returns, but the risks are broader than what Australian history alone suggests.


For investors and retirees today, care needs to be taken drawing conclusions from long-term averages when planning for the future. In addition, a set and forget approach will not ensure that a retiree’s exposure to equities risk will be appropriately mitigated.


Jeremy Cooper is Chairman of Retirement Incomes at Challenger, and chaired the Super System Review (the ‘Cooper Review’).


Jeff Oughton
July 14, 2021

No surprises here in actual nominal returns and ERP…albeit keen to read the underlying research

Macro economists know that real g, real r etc are stochastic … and often involve structural issues …and non mean reverting …take a look at the long run ups and downs and the secular decline in real r and g … and other structural changes in the listed businesses

and then listed equity returns to shareholders ..should also take account of tax etc

February 25, 2016

As of two days ago, the ASX 200 index returned 0% over 10 years.

Thanks God for dividends.

Mark Hayden
February 25, 2016

Jeremy has missed a crucial point. The Folly of Point to Point analysis, as I have termed it, is that no investor invests everything on one day and then cashes it all in on another day. No-one invests 100% at Time 0 and redeems it all at Time 20. If an analyst finds a bad period of 20 years, then history will show the period before Time 0 was probably very good. Superannuants progressively build a portfolio and Allocated Pensioners progressively draw-down their funds.

It is an undisputed fact that past performance affects the “new” starting point, and hence affects future returns. If we go back to March 2009 a Jeremy-inspired investor would spin a chocolate wheel and may assume they could receive the “worst ever” 20 year return but a Rational Investor will realise this is impossible because of the starting point. For example the 20 year returns from another date, eg December 2007, would have generated a poorer return.

Both economic principles and historical data support the hypothesis that after a sizable period of very good (or very bad) returns the future returns are less likely to very good (or very bad). I welcome wise, rational analysis of long-term investing. I hope Cuffelinks can provide some good articles on this topic.

Aaron Minney
February 26, 2016

I work with Jeremy and have looked at the data behind this paper in detail.
You make a great point about the impact of history.
However, how can anyone get the timing right? Greenspan made the same point about the US equity market in 1996 when he questioned irrational exuberance. The timing was so out that selling then was an unprofitable long term decision.
The point of Jeremy's article is that a goals-based approach aims to provide retirees with the peace of mind that the market swings don't impact their essential (and short term) needs. Maximising long term investments should come after this.
A note on historical data: The mean reversion doesn't always work. In 1988, the 20 year (1968-1988) historical ERP was lower than any other period that didn't include the 1930s Great Depression. That didn't make it a good starting point because the next 20 years produced one of the worst periods to date (1988-2008) with a negative ERP. You would have been better off staying in Government bonds than buying those 'cheap' stocks after the 1987 crash.

Mark Hayden
February 26, 2016

Hi Aaron & Jeremy

Unfortunately you are complicating matters. Whilst I appreciate your aim is to provide retirees with peace of mind, I find your approach is flawed. The ERP data needs to allow for the fact that no-one invests 100% at Time 0 (some is at T-1, T-2 etc) and no rational investor redeems 100% at Time 20. Soundly based long-term investments are rewarded by historical data and by economic theory. You mentioned market timing, not me, but my position is that no-one needs to get it right. Also, the Hayden Investment Model would never say to sell significant amounts in 1996 nor to buy significant amounts in 1988.

February 25, 2016

Brilliant article that has changed how I think

Jeremy Cooper
February 25, 2016

Actually Mark, the chocolate wheel sums up long term investing pretty well. The chocolate wheel illustrates the global historical annual ERP averaged over 20 year periods. It is not a single year ERP. 20 years is about as long as an ordinary retiree could hold equities without touching them, so I think that’s pretty long run. The variability just highlights what investors have received for investing in equities over government bonds for 20 year periods. It hasn't been consistent. Investors have an expectation that they will get the long term average ERP over such a long period, but this study shows that is not the case..
The real value of the ERP is its forward-looking nature, rather than the historical example here. How much should investors be paying today for the profits that will be made in 2036? Equities are effectively a leveraged exposure to GDP growth after all.

Mark Hayden
February 25, 2016

Unfortunately Jeremy has not understood some key facts about long-term investing. To compare long-term returns to a chocolate wheel is very disappointing. Next years' returns is obviously not independent of last years' return. Especially if you consider the underlying businesses. His excerpts about the Equity Risk Premium are not a fair analysis. The ERP exists partially because of the fundamentals of market economies - in effect, consumers are comfortable with a reasonable profit level for those businesses that supply products and services that they, as consumers, want.


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